An Update on Real Estate

Dear Reader,

Last weekend, I attended a house party with a lot of other people from the Balkans and as is often the case, the conversation turned to European politics. One of the attendants from Serbia recalled a common saying from decades ago that is gaining popularity again: "Duzan kao Grcka." It means "in debt like Greece." By recalling the saying, he made an interesting point: was the Greek debt crisis really that difficult to figure out?

Granted, holding this viewpoint requires accepting some stereotypes, but it appears the stereotypes fit. The rest of the economically troubled countries in southeastern Europe have always considered Greece a backward comrade as well – just as messed up as anyone else. But for some reason, the rest of the world began viewing Greece as if it were some sort of modern, first-world nation rather than part of the Eastern European bloc.

In many ways, this is true for Italy as well. Just recently, no one in Europe thought that Italy was an economic powerhouse that could take on vast amounts of debt. Europeans commonly thought of Italy as a chronically dysfunctional country with rarely industrious people and bad inflation. Of course, Italy was still a decent place to live, but it was certainly no Germany nor even France. If Italy had any redeeming qualities, it was its tourism, leather products, coffee, cars, and suits, but that was about it. Yet over the last few years, the country revamped its image as a key member of the Eurozone.

Beyond Italy and Greece, there are other countries that fit the same pattern. Think about Ireland and Argentina. The case for Ireland doesn't even require a European background to comprehend. Every American knows that Ireland has been seriously messed up since almost the beginning of time, and guess what….it's messed up again. Argentina had massive inflation only a decade ago. Everyone thought that surely the country had learned its lesson, but today estimates of Argentina's inflation reach as high as 30%.

Sometimes financial markets are just too forgiving. They assume that these countries have finally learned their lessons. The same has been true of lending to the former Soviet bloc. Many new nations have gained sizeable debt burdens in only two short decades. It's easy to see how investors are lured into these deals. Until there's trouble, emerging economies always sound enticing. And after all, can one really stereotype a country? Why should the government or inflation of decades ago scare the investors of today? Yet, somehow the past keeps repeating itself in these places, and investors keep falling for the allure of a transformed, emerging economy.

Up next, we have an article by Andy Miller on the top risk exposures in the real-estate market going forward. Andy Miller, cofounder of Miller Frishman Group, is a regular contributor on the topic of real estate to The Casey Report and a very popular faculty member at the Casey Summit series. For decades Andy has been involved in all aspects of the US real estate industry, including building, managing, and financing large inventories of commercial real estate, and providing workout services on troubled real estate for major financial institutions across the country. Andy was one of the few real-estate professionals to sell the bulk of his holdings in anticipation of the end of the housing bubble. In other words, when he talks, we listen. Here's his latest, quick update.


Real Estate: An Update

By Andy Miller

The real estate market is very interesting. For the most part, it seems everyone has the giggles. However, there are major exposures lurking. Here are the top exposures I'm keeping an eye on:

  1. Interest rates. In real estate interest rates are important, not just because of the debt service one pays, but because all value in real estate is determined by capitalization rates. If interest rates increase, cap rates increase. This would be devastating to values. I think the risk of rising interest rates far outweighs any reward present in today's market.
     
  2. Operating expenses. Real estate is heavily impacted by operating expenses. We have already seen expenses increase for every product type, in every market. Any sort of inflation will have a major impact on the value of real estate – and it already has.
     
  3. Change in tenant make-up. Obviously, businesses come and go, industries expand and contract. However, I believe we are now witnessing a large shift in tenant uses. Retail shopping centers may be the most visible example, but it is clear that the office building business is changing, as well aswarehouse and storage businesses.
     
  4. Geography is now becoming a more salient factor than it ever has been. We have always used location, location, and location. However, it seems to me that entire swaths of the country should now be re-examined for their viability as long-term real estate holdings. For example, would anything be appealing in Detroit or Cleveland? I think not. That could have huge ramifications for real estate in the future.
     
  5. Housing. Apartments are on fire. I have rarely seen as many apartment units planned as are now on the drawing board. It is staggering. In Denver, there are at least 14,000 units planned or under construction. This will all be financed through Fannie, Freddie, or HUD. In addition, the rents that need to be obtained in new multifamily units are quite high as a result of increasing construction costs. This is all occurring with the backdrop of a weak and perhaps weakening housing market.

    The housing market under $250,000 is active and seemingly stabilizing. However, the jumbo markets are deteriorating steadily. As you know, the GSEs and HUD do not finance homes over $417,000 in most of the country. Therefore, if a home requires a loan over that amount, it is likely that one will have to write a check for 20-25% for equity. So, a borrower looking to finance a home with a price of $600,000 will likely have to write a check to get the loan in the amount of, at least, $120,000. In this day and age of volatility and negative savings, there isn't a plethora of borrowers running around who can do that. As a result, the jumbo markets are damaged.

    There have been two generations of homeowners who have been psychologically and financially debilitated by this housing depression. That is why apartments are so hot. Apartments represent more flexibility for people today. Renters don’t need a down payment; they can move at the end of a lease, etc. However, as I like to say, "Housing is housing." True, apartments may be more appealing today. However, I see massive efforts under way by lenders and the GSEs to organize rental programs for single-family homes taken back in foreclosures. Once on the market, a rental home has far more appeal to a resident than an apartment. All things being equal, the home should rent faster than the apartment. This is an imbalance that we are watching carefully. When one considers the foregoing and the other risk factors confronting real estate, I think apartments are very risky to build new today.
     
  6. No recovery in sight. As I have said many times, there is no recovery going on in real estate. However, I also don't see a great deal of erosion. Institutional buyers and funds are still gobbling up high-profile properties at very aggressive prices. This is having an impact on the market for all product types. However, rents are not going up; expenses are not going down; and vacancy rates are not being mitigated. Therefore, the underlying fundamentals of commercial properties are not improving. It sounds crazy to say that prices are high, but it is true. It is inexplicable, but true.

That's it from the trenches. We continue to fix our bayonets and run into battle.

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Additional Links and Reads

Pimco CEO: US Risks a Lost Decade (Real Clear Markets)

El-Erian from Pimco lays out the case for a Japanese-style lost decade in the US. This is a really great interview because it's very even-handed. He explains how our problems resemble Japan's, how things could be even worse here, and what advantages the US possesses over Japan. Usually interviews just want a couple of sound bites, but El-Erian covers nearly all the bases intelligently and succinctly.

The Paulson Rumors Are True (Zero Hedge)

John Paulson – one of the stars who bet against the subprime crash – is quickly losing his shine. Not only has his fund struggled as of late, but it appears that he's doubling down on some of his bad bets while letting the winners go… never a good sign. From Q2 to Q3, he trimmed down his shares of GLD by over a third, from 31.5 million to 20.2 million. On top of that, he has added to his Capital One and Bank of America positions.

As I've noted before, Paulson has a too simplistic view of the business cycle. He didn't really understand what was coming in 2008 and thus only got half the story right. Paulson saw a regular business cycle with a market crash followed by the usual rapid recovery. That's not what happened. This was a crash followed by a prolonged slump and as a result, his fund has been hurt by leveraged plays expecting a recovery at any moment. Nonetheless, being half right is still better than almost everyone else who was 100% wrong.

Why Americans Won't Do Dirty Jobs (Bloomberg Businessweek)

This is a well-written story; however, it doesn't come with a whole lot of statistics. Alabama recently passed one of the nation's toughest immigration laws which would force schools to ascertain the immigration status of students and their parents. As a result, illegal immigrants are leaving Alabama in droves. The unintended consequence – as this story points out – is an extreme shortage of workers for the dirty jobs many immigrants performed beforehand. Even with the recession, it appears that many locals refuse to do the work. Instead of opening more jobs for Americans, it appears that the state's new law may just discourage other businesses from locating in Alabama.

That's it for today. Thank you for reading and subscribing to Casey Daily Dispatch.

Vedran Vuk
Casey Daily Dispatch Editor

Nov 15, 2011